Carbon credits questionable as strategic investments

Improvements are needed in the young market, according to a new Morningstar report

carbon credits


Emile Hallez

Carbon credits show potential for environmental impact — but people should think twice before using them as strategic investments, a report today from Morningstar cautions.

The reasons for that: It’s all but impossible to accurately peg the future financial costs to society of burning carbon today in order to set caps, and the young carbon credits market does not appear to respond much to energy prices.

“Our hypothesis going in was that carbon credits might have a straightforward relationship with energy markets,” said Madeline Hume, author of the Carbon Credits Landscape report and senior research analyst at Morningstar. “One thing that surprised us was how little carbon credits respond to fossil fuel prices in a predictable manner.”

Over five years, the European Union’s carbon credit prices “moved with energy prices just as frequently as they moved against it” during rolling six-month timeframes, the report noted.

Further, cap-and-trade programs vary widely by geography, with many differences in emissions standards. Thus, carbon credit prices can range from just over $1 in Kazakhstan to nearly $100 in the UK, according to the report.

Different standards

Only four programs — those of New Zealand, Switzerland, the EU and UK — have carbon credit prices above $50, high enough to meet Paris Climate Accord targets of a 2 degree C average temperature rise, the report found.

In the US, about a dozen states participate in the Regional Greenhouse Gas Initiative, a mandatory cap-and-trade program. Massachusetts also has a program, and California participates in one that has a sister program in Quebec.

The California and Quebec programs have carbon credits priced at about $30, according to Morningstar’s report.

Such programs are much bigger than the voluntary carbon markets, with compliance carbon programs now covering about 17% of the world’s greenhouse gas emissions, and another 13% when including programs that are still in development, the report noted.

Voluntary carbon markets, which include carbon offsets, have been growing at a rate of 45% annually, although they represented just over 350 megatons of carbon dioxide equivalents in 2021, compared with nearly 8,600 megatons in carbon compliance programs, according to the report. The size of compliance coverage shot up dramatically in 2021 with the debut of China’s system.

That contrast may provide evidence that regulation, rather than relying on voluntary participation from industries, is necessary to make real progress in cutting emissions.

However, the passage of the Inflation Reduction Act and its numerous climate strategy components that rely on tax benefits refutes the notion that negative consequences alone are effective, Hume noted.

“Any programs that are punitive in nature poll pretty poorly. It’s difficult for these regulators once these programs are passed to continue enforcing them,” she said.

Limited effect

Morningstar analyzed the four cap-and-trade programs that saw the highest scores from the firm across maturity, depth of emissions covered, size of market, breadth of sectors and how easily they can be invested in. Among those programs, in California, Quebec, the EU and South Korea, the EU’s program proved to be the most successful at reducing emissions, according to Morningstar.

“From our point of view, the most effective thing a cap-and-trade program can do on behalf of an investor is craft a price-discovery mechanism that makes carbon a comparable investment throughout time and across jurisdictions,” the report stated. “This will discourage producers against investing additional capital in inefficient energy sources and over time should bring emissions within covered sectors to heel.”

Investor demand

There were only about 10 firms investing in carbon markets in 2016, and that number has since grown to at least 40, according to the report. Asset managers have been the slowest to move on the space, with four firms participating, compared with 10 commodities firms, nine venture capital firms and seven hedge funds.

“Today, most funds treat carbon credits as a commodity, and they gain exposure by buying futures or purchasing the spot in a secondary market. As a derivative of an asset, revenue from futures contracts goes to the counterparty that writes the contract as opposed to the governments that created the credits. Rather than exercising them, funds typically sell futures back to the highest bidder when they roll forward the contracts,” the report noted.

That system could be improved if funds bought carbon credits at auction and later use proceeds for green energy projects, according to the paper. Further, funds with exposure only through futures could take delivery of the credits, “temporarily reducing the amount of credits available for emissions” and then sell positions to carbon-offset programs.

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